We Think Chiho Environmental Group (HKG:976) Is Taking Some Risk With Its Debt

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that Chiho Environmental Group Limited (HKG:976) does use debt in its business. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Chiho Environmental Group

How Much Debt Does Chiho Environmental Group Carry?

The image below, which you can click on for greater detail, shows that Chiho Environmental Group had debt of HK$1.66b at the end of December 2021, a reduction from HK$2.30b over a year. However, it also had HK$782.3m in cash, and so its net debt is HK$879.6m.

How Strong Is Chiho Environmental Group's Balance Sheet?

The latest balance sheet data shows that Chiho Environmental Group had liabilities of HK$4.43b due within a year, and liabilities of HK$672.4m falling due after that. Offsetting this, it had HK$782.3m in cash and HK$2.26b in receivables that were due within 12 months. So it has liabilities totalling HK$2.06b more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company's market capitalization of HK$1.91b, we think shareholders really should watch Chiho Environmental Group's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Looking at its net debt to EBITDA of 0.98 and interest cover of 2.7 times, it seems to us that Chiho Environmental Group is probably using debt in a pretty reasonable way. So we'd recommend keeping a close eye on the impact financing costs are having on the business. We also note that Chiho Environmental Group improved its EBIT from a last year's loss to a positive HK$643m. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Chiho Environmental Group will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Over the last year, Chiho Environmental Group recorded negative free cash flow, in total. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.

Our View

On the face of it, Chiho Environmental Group's interest cover left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at managing its debt, based on its EBITDA,; that's encouraging. Looking at the bigger picture, it seems clear to us that Chiho Environmental Group's use of debt is creating risks for the company. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. To that end, you should be aware of the 1 warning sign we've spotted with Chiho Environmental Group .

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.